Are industrial stocks hot again?

Bryan Borzykowski

About the author

Bryan Borzykowski is a Toronto-based business writer and editor. He writes about personal finance, wealth issues and other money topics for BBC Capital and also contributes to the New York Times, CNBC, CNNMoney, Canadian Business and the Globe and Mail. He’s written three investing and personal finance books, too. Follow him on Twitter @bborzyko.

If you’ve ever dreamed of owning an
airplane or being a railroad baron, now may be your chance. You won’t actually
get to keep that plane or train in your personal hanger, but you can live out
your business magnate fantasies by owning stock in the roaring industrial
sector.

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The category, which goes by investor shorthand ‘industrials’, includes aircraft manufacturers, railroad companies, trucking operations and heavy equipment makers. When economies are in a downturn, their sales lag and their stocks do, too — but their shares outperform the market when economies are booming.

Of course, not all industrials are created equal. Investors need to know where to look — both by sector and region of the world — and determine how a company is generating its revenues in order to choose the right ones to add to their portfolio.

An economically sensitive sector

The world’s gross domestic product — the monetary value of all the goods and services that countries produce — is expected to expand by about 3.6% in 2014. That is the biggest gain since 2010 and many investment experts are telling retail investors that now might be a good time to jump into the industrial sector.

There are several reasons why the industrial sector outperforms in improving markets, but the main driver comes down to basic economics. When companies that need industrial products are doing well, they’re more willing to spend money on equipment. That translates into sales and profits for industrials.

For instance, the aerospace sector is seeing a record backlog of airplane orders, said Johnson. Why? Because more people are flying. Passenger traffic is at all-time highs, which makes airlines more profitable and more willing to spend money on new aircrafts, he said.

Industrial companies are also able to more easily increase operating margins in better economic conditions, said Matthew Beesley, a London-based director of global equities with Henderson Global Investors. Operating margin, an important measure of company strength, shows how much revenue remains after paying for fixed costs such as wages.

These fixed costs don’t usually change, so when companies make more money operation margins instantly grow. When they make less margins shrink, he said.

Investors have already missed out on some strong gains, as global industrials are up 22% year-to-date, according to MSCI. It’s highly possible that the sector won’t match those returns next year, but Russ Koesterich, BlackRock’s San Francisco-based chief investment strategist still thinks the industry will outperform the broader market.

He expects earnings in the sector to grow by about 12% over the next 12 months, compared to about 10% for the S&P 500.

Still, income oriented investors may find better opportunities elsewhere. Dividend yields are modest, at around 2%, and it’s not clear how much they’ll grow in this environment, said Johnson.

The sector is geared more to those in search of growth companies that can be bought at reasonable valuations. Koesterich pointed out that industrials are slightly cheaper than the US market. The companies in the S&P 500 collectively currently trade at around 19 times earnings, while the industrial sector is trading at about 17 times earnings. All of that adds up to a good opportunity, he said.

Where to lookWhile there are industrial companies in nearly every country, some locales offer better options than others.Consider looking at companies in Europe and Japan, said Koesterich. The European market, in general, is cheaper than the US. And Japan’s economy is accelerating again after several years of little growth.

While Beesley said he also thinks European-based industrials offer good value, he said he focuses more where companies sell their products, rather than where they are headquartered. With emerging market growth slowing, he is partial to companies that sell into North America, Europe and Japan.

Swedish truck manufacturer AB Volvo is a good example, he said. It is based in Sweden, but most of its business is being done in the US, Latin America and other parts of Europe.

“That spread of revenues is important,” he said.

Some groups within the broader industrial sector are expected to benefit particularly well from an improving economy. Johnson likes aerospace because it only has two big players, Boeing and EADS (the makers of Airbus), and demand for air travel is growing.

Equipment and transportation manufacturers are a good bet too, said Beesley. Many equipment buyers held off purchasing new goods during the recession, but now that the global economy is healthier and companies have more cash to spend, they’ll soon start buying machinery and vehicles again.

Beesley said he finds US engine and fuel systems maker Cummins Inc and Pentair Ltd, a Swiss company that makes water filtration and heating and cooling equipment, attractive today.

Company characteristics

Beyond the sub-industry and the geographic makeup of the company, for Johnson, a company needs to have some competitive advantage that will not only make it profitable an improving economy, but will keep customers coming in during downturns.

He also looks for firms where the management team doesn’t overpay for acquisitions. If it spends too freely, it may not have enough dough to get it through rough patches. Johnson prefers that companies not pay more than a 40% premium to the share price.

Industrial sector cycles typically last about eight years and Beesley thinks we’re in year four of the upswing.

Investors should take a close look at this sector now, said Beesley. If they wait too long the cycle could end, he added. “All things being equal, industrials should do better,” said Beesley.

This story was produced under the BBC's guidelines for financial journalism. A full version of those guidelines can be found at bbc.co.uk/guidelines.